The lie you’ve been told with cash flow and capital gains

This opinion seems to have remained substantially unchallenged by academics and the media, and as much fun as it is watching the intellectual cage fight unfold, I believe there’s a simple answer to this question.

The fallacy you’ve been fed

The traditional narrative that’s sold to us as investors is each potential property has drivers that fall in favour of either cash flow or capital gains.

For high cash flow holdings, it’s said they’ll be located in areas of high tenant demand. They will offer the ability to achieve more return per dollar outlaid in purchase because every possible square metre of space is being utilised for renter appeal.

They will be in locations where strong employment, particularly for transient workers with high paying jobs, will see renters fighting over the available stock.

Many believe high cash flow properties rarely achieve decent capital gains.

For capital growth holdings, it’s believed these will be located in suburbs where homeowner demand is huge. Great schools, convenient shopping and ready access to a CBD is a must apparently.

According to this argument, capital growth property is best found in blue-chip inner-city locations. It will be unique in design and appeal which improves its scarcity factor. This sort of ‘limitation of supply’ supposedly translates into stronger growth.

Classic blue-chip holdings are deemed to be detached houses in high price addresses that avoid secondary fundamentals such as busy road frontages or undesirable neighbours like service stations.

The risks of each

Both approaches to investing have their benefits and flaws.

High cash flow is great if your available funds for investing are limited. The high yield will help you service the loan and stay ahead of repayments.

The downside is, as a gross generalisation, high yield does not create the sort of long-term returns that help investors achieve real wealth. It may put you into a comfortable position, but the capital value upside is limited.

In addition, if you buy high yield in a regional centre that relies on a limited economic base of, say, one major employer, they can be risky.

Ask anyone who was enjoying their seven-plus per cent yield in one of Queensland’s mining centres a few years back, but held out for more. They’re in a world of hurt now.

With high growth, the long-term upside is excellent. It’s a passive way to build extraordinary wealth, because if you hold $1 million-dollar property in a location where values go up by six per cent per year, this translates to growth of $60,000.

High growth also works with the magic of compounding which sees exponential value rises over a long time. The longer you hold it, the wealthier you’ll be.

There is a downside however. High growth, blue-chip usually costs more to acquire and many investors will overextend themselves to become landlords.

In addition, the relatively low yield will not assist all that much in servicing the loan. High-growth investors need to be super careful. A rise in interest rates or unexpected job loss can be devastating.

The solution

To me, the answer is simple.

I believe you must first determine what you can afford to pay and where the best growth potential locations are for your price point.

Next, you should look at property types within your location that will appeal to the local renter base.

For example, if most of the tenants are students, don’t look for a home with high-end finishes and plenty of family space. Seek a practical layout with the potential for privacy. Perhaps you will find a duplex or triplex in this growth zone?

If you can achieve the best possible yield in a growth location, it buys you time in the market, and time is your friend.

Look for property that has a future twist too – for example, a home that could renovated or a block that could redeveloped that will generate additional equity down the track.

Happy hunting.